Abstract
A small open economy operates with a unionized import-competing sector and an informal “self-employed” sector. Productivity varies across people in the informal sector. The full-employment structure accommodates “underemployment or involuntary self-employment” in the flexible-wage informal sector. Protection increases the cost of capital and may increase the set of people who are involuntarily employed in the informal sector. Even if one ignores the consumption distortion effect of a tariff, the tariff may fail to be second-best because it may raise underemployment. Our results on tariff-reform are consistent with some recent empirical evidence.
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